Chuck Jaffe: Detroit a sign to dump muni bond funds?

Money has been marching steadily out of municipal bond funds for about two months now, but with the recent news of Detroit’s bankruptcy claim, a lot of individual investors have wondered whether they should join the parade.

Despite the scary headlines, most fund experts say that, if anything, the headlines make this the wrong time to abandon muni bonds.

What’s more, the lack of a frightening muni-bond fund story — the issue that blew up because it had become bogged down with Detroit bonds and was taken by surprise — may be the best sign that fund managers understood the risks they were facing even before the Michigan situation attracted attention to muni bonds.

There’s no denying the black eye this has given the municipals market, but the question is whether that pain is more a buying opportunity than a warning sign to sell.

“Any fund manager worth his salt has seen this coming, as Detroit’s problems did not pop overnight — they were well publicized and covered in muni circles,” said Christopher Keith, who manages bond portfolios at Adviser Investments in Newton, Mass.

“This means that your higher-quality focused portfolio managers had time to work out of their positions or, at the very least, reduce exposure to the point where it will not cause noticeable harm.

“Despite this and other highly publicized pockets of trouble, municipal bonds remain a safe, low-risk and conservative asset class,” he added.

It just doesn’t feel so safe when default risk rears its ugly head.

Bond defaults of all stripes have been rare in recent years, but particularly so in the muni space.

That said, in every past case of a major community default — think of the Orange County bankruptcy of 1994 — fund companies have in many cases stepped in to buy the paper affected by the problems, relieving their issues of troubled paper, stemming the tide and minimizing losses.

There’s no guarantee that will happen again, but there’s also no reason to expect Detroit’s situation to trigger some sort of rush to the bankruptcy court.

There are many other municipalities with revenue shortfalls and underfunded pensions that will be watching the proceedings and using Detroit as a test case, but they will also use the negative fallout from the problem to push for legislative and administrative change, rather than immediately moving to a last-resort solution like bankruptcy.

As the Detroit case proceeds, there is a legitimate concern that the city could try to get a court to rule that general-obligation bonds — those tied to using resources like tax revenues to repay bondholders — should be treated as unsecured debts.

That would mean that the city would no longer be on the hook if declining revenues — caused by Detroit’s shrinking population base — were insufficient to cover the debts.

That said, most muni-fund managers balance general-obligation bonds with essential-purpose bonds — like a water- or sewer-utility bond — which are not likely to be affected by the bankruptcy proceeding at all.

In the case of Detroit, the water and sewer system is self-sufficient, with adequate revenue to make its debt payments; while prices on the water and sewer bonds have fallen since the bankruptcy, most money managers see this as a buying opportunity.

For investors who are worried about general-obligation holdings if they become less-secure after the Detroit case, a simple check of a mutual-fund’s portfolio should let them see what they are dealing with.

There are muni funds that, as a policy, avoid general-obligation bonds; the recently opened db X-trackers Municipal Infrastructure Revenue Bond ETF (RVNU) is the first exchange-traded fund to stake out that space.

Detroit bonds, also, represent a small part of the muni market.

Russ Koesterich, chief investment strategist for BlackRock, said, “There are still good opportunities at the national level in the muni market and this is not an asset class you want to abandon, because the tax equivalent yield is still very competitive compared to the rest of the bond market.”

Indeed, the Detroit situation has made munis a bargain, relatively speaking.

Mark Salzinger, editor of the No-Load Fund Investor newsletter, noted that the yield on Vanguard Intermediate-Term Tax Exempt (VWITX) is now more than a full percentage point higher than its government-bond-buying sister, Vanguard Intermediate-Term Treasury (VFITX).

While Detroit will be a trigger point for some nervous, risk-averse investors, the truth is that the real worry isn’t default or bankruptcy risk so much as plain-old, ordinary interest-rate risk. A move in rates will hurt muni funds — and all types of bond funds — more than Detroit’s situation.

Said Salzinger: “With absolute yields across fixed income so low, investors of all risk levels should have less in fixed income products than they normally would. However, compared with other types of bonds, municipals look pretty good now.”

Chuck Jaffe is senior columnist for MarketWatch. He can be reached at cjaffe@marketwatch.com or at P.O. Box 70, Cohasset, MA 02025-0070.